Transfer Pricing Challenges with TNMM: Lessons from the SABIC India Case for all Multinationals

Transfer pricing has become one of the most contentious areas in international taxation, particularly for multinational enterprises navigating cross-border transactions. Central to transfer pricing compliance is the application of methods that ensure an arm’s length price (ALP) for related-party transactions. The Transactional Net Margin Method (TNMM) has been widely regarded as a reliable approach, especially for service-oriented transactions. However, the SABIC India case, decided by the High Court of Delhi in October 2024, illustrates the complexities and challenges of applying TNMM. This article explores the implications of the SABIC India judgment (summarised by The Academy of Tax Law), its significance for MNEs, and the importance of expert guidance in mitigating transfer pricing risks.

Case Analysis

The SABIC India case revolves around the rejection of TNMM by the Transfer Pricing Officer (TPO) and the adoption of the residual “other method” under Rule 10B(1)(f) of the Income Tax Rules, 1962. SABIC India Pvt Ltd, a wholly owned subsidiary of the SABIC Group, provides marketing support services to its Associated Enterprises (AEs) without taking ownership of goods or entering into direct contracts with customers. For Assessment Year (AY) 2016-17, SABIC India benchmarked its international transactions using TNMM, a method consistently applied and accepted in prior years.

The TPO, however, rejected TNMM, arguing that SABIC India’s functional profile as a commission agent rendered the method unsuitable. Instead, the TPO adopted the “other method,” determining a median commission rate of 5% and making an upward adjustment of ₹3.61 billion to SABIC India’s declared income. The Income Tax Appellate Tribunal (ITAT) overturned the TPO’s adjustment, and the High Court upheld the ITAT’s decision, citing the following key reasons:

1. Inadequate Justification for Rejecting TNMM: The TPO failed to provide substantial reasons for rejecting TNMM, which had been consistently applied in prior years. The High Court emphasized that deviations from established methodologies require compelling and well-documented reasoning. In this case, the TPO did not demonstrate any material changes in SABIC India’s functional or economic profile that would render TNMM inapplicable. Furthermore, the TPO’s concerns about the comparables selected by SABIC India were not sufficient grounds for rejecting the method itself, as these could have been addressed within the TNMM framework. This lack of justification created uncertainty and inconsistency in tax assessments, undermining the credibility of the adjustment.
2. Flawed Comparables: The comparables used under the residual method were irrelevant and inconsistent with SABIC India’s business model. For instance, agreements involving non-compete clauses and educational services were used as benchmarks for a marketing support entity. Such transactions bear no resemblance to the commission-based services provided by SABIC India. The High Court noted that the TPO’s failure to select relevant comparables undermined the reliability of the residual method’s application. This highlighted the importance of aligning comparables with the taxpayer’s functional and economic profile to ensure credible benchmarking.
3. Non-Adherence to Guidelines: The TPO did not exhaustively justify the rejection of all standard methods before resorting to the residual method, as required by the OECD and ICAI guidelines. These guidelines mandate a step-by-step evaluation of each method to determine its applicability and require detailed reasoning for rejecting methods that have been historically accepted. In this case, the TPO’s decision to bypass TNMM and the other four standard methods was not supported by comprehensive analysis or documentation. The Court reiterated that the residual method is a method of last resort and must be employed only when no standard method is suitable—a condition that was not satisfied in this instance.

Comparative Analysis of Relevant Cases

1. Li & Fung India vs CIT (2014): In this case, the Delhi High Court upheld TNMM as the most appropriate method for benchmarking sourcing services provided by Li & Fung India to its AEs. The Court emphasized that TNMM is particularly suitable for service-oriented functions with limited risks and assets, aligning closely with the facts of the SABIC India case. This precedent underscores the importance of consistency in applying TNMM and addresses the challenges of selecting appropriate comparables within its framework.
2. Sumitomo Corporation India vs CIT (2016): The Court validated the use of TNMM with the Berry ratio as a profit-level indicator for service-oriented entities. The judgment highlighted that TNMM could effectively capture the value-added contributions of entities engaged in intermediary services, similar to SABIC India’s marketing support functions. This case reinforces TNMM’s applicability for benchmarking limited-function entities operating as commission agents.
3. Radhasoami Satsang vs CIT (1992): While primarily a case on the principle of consistency, the Supreme Court’s ruling in Radhasoami Satsang has been widely cited in transfer pricing disputes. It establishes that methodologies consistently applied in prior years should not be disregarded without substantial justification. This principle was central to the SABIC India judgment, which critiqued the TPO for abruptly rejecting TNMM without cogent reasons.

Additional International Cases

1. GlaxoSmithKline Inc. vs Canada (2006): This Canadian case highlighted the importance of comparability and the challenges of benchmarking transactions involving intangibles and unique business models. Although different in scope, it underscores the need for robust documentation and justification when deviating from established methodologies.
2. Coca-Cola Co. vs IRS (2020): The U.S. Tax Court ruled on the applicability of transfer pricing adjustments related to Coca-Cola’s royalty payments. The case emphasized the importance of adhering to established transfer pricing guidelines and the risks associated with arbitrary adjustments by tax authorities.
3. GE Capital Canada vs The Queen (2010): This case dealt with the arm’s length pricing of intra-group financial transactions and highlighted the necessity of selecting comparables that align closely with the taxpayer’s functional and risk profile. The emphasis on comparability resonates with the issues in the SABIC India case.

Preventative Measures and Best Practices

To avoid disputes similar to the SABIC India case, MNEs should adopt the following measures:

1. Establish Tax Steering Committees: Ensure alignment of tax policies with broader business strategies and vet transactions for tax implications. (Download this FREE eBook – Driving Tax Compliance: The Essential Role of the Tax Steering Committee)
2. Implement Advance Pricing Agreements (APAs): Secure certainty on transfer pricing methodologies by entering into APAs with tax authorities.
3. Regular Compliance Reviews: Conduct periodic reviews of transfer pricing policies to align with evolving regulations.
4. Capacity Building: Equip internal teams with knowledge of transfer pricing regulations and best practices.

The SABIC India judgment reaffirms the importance of TNMM and the need for consistency, transparency, and robust documentation. For MNEs, the case highlights the necessity of engaging experienced tax practitioners and adopting proactive measures to manage transfer pricing risks. As the global tax environment continues to evolve, the lessons from SABIC India will remain a cornerstone for navigating the complexities of international taxation.

Please do not hesitate to contact me for any additional information or insight into this and any Transfer Pricing/ International Tax matters.